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Are high valuations a risk—or an opportunity? After two years of strong equity returns, valuations sit at historical highs—raising questions about future market performance. While elevated valuations can signal lower long-term returns, structural shifts like AI-driven innovation and broadening earnings growth may tell a different story. With uneven advances creating opportunities, we believe selectivity will be key in 2025.
Key Points
- Valuations have reached the high end of their historical range, following consecutive years of strong returns.
- High starting valuations have often been associated with lower long-term returns historically, which might contribute to increased downside risks in the near term.
- The uneven advance of equity markets presents investors with the opportunity to take a long-term perspective in identifying businesses that may be well-positioned to grow profits, potentially offsetting valuation concerns.
Unraveling Valuations: Growth, Scarcity, and the Shifting Makeup of the U.S. Economy
In 2024, strong earnings growth and positive earnings revisions for the Magnificent Seven, a shift toward more accommodative monetary policy, and enthusiasm for the potential of generative artificial intelligence (AI) drove a historically large advance in equities. These factors resulted in a 24.9 percent return for U.S. equities (as measured by the S&P 500), with roughly equal contributions from earnings and multiple expansion.
Despite persistent increases in real yields, 2024 marked the second consecutive year of equity returns exceeding 20 percent—one of the strongest two-year stretches in recent history. This divergence between bond yields and equity valuations has pushed the equity risk premium to its lowest level since 2002. We believe this shift reflects growing confidence in future earnings growth, with traditional valuation metrics now positioned at the higher end of historical ranges.
Research shows that starting valuation has helped to predict long-term equity market returns1. Over one-to-three-year periods, high valuations may increase downside risks, especially in areas with heightened expectations, outsized positioning (“crowding”), and high momentum. However, high valuations are less predictive of returns in the short run.
In our view, when assessing valuations, it’s important to note the factors that may support structurally higher valuations, including:
- Higher profit margins and a persistent rise in return on equity, predominantly due to the influence of the information technology sector.
- Increasing scarcity as the number of publicly listed U.S. companies has
fallen to 4,642, nearly half of the 1996 peak.2 There has been a three-year decline in the supply of equities from 2022 through 2024.
free cash flow margins
Margin Expansion Supports Higher Valuations
- A persistent rise in payout ratios to roughly 70 percent—up from a long-term historical average of approximately 50 percent.
- An increasing percentage of market capitalization taken up by less-cyclical industries (information technology, communication services, and healthcare), which command higher valuation multiples. This shift reflects a 20-year reduction in capital intensity and corporations getting greater productivity from labor. These changes have reduced volatility in gross margins.
U.S. Listed Public Companies Hit 40-Year Low Amid Falling Equity Supply
Number of Public Companies Listed
IPOs and Stock Compensation Issuance*
We believe the following factors will be key determinants of equity market returns over the next one to two years.
Broadening Earnings Growth
Earnings growth in 2024 was largely driven by the Magnificent Seven, as shown in the chart below. We view broadening strength in earnings growth, paired with more reasonable valuations for smaller-capitalization businesses, as a potential tailwind. Moreover, the ability of businesses to deliver positive earnings revisions—a key determinant of equity market returns when valuations are elevated3—is critical.
The Combination of Accelerating Earnings Growth and a Valuation Discount for the S&P 493 May Support Market Breadth
EPS Growth Premium Poised to Narrow Sharply in 2025
Higher Valuation for Magnificent 7 Stocks vs. S&P 493
Policy Tug-of-War
Potential tailwinds from deregulation may clash with inflationary policies on tariffs and stricter immigration. History shows positive equity returns typically coincide with rate-cutting cycles that are not followed by a recession. Any change to the growth or inflation outlook has implications for this historical relationship.
The Sustainability of AI Infrastructure Spending
In 2024, equity markets responded strongly to expectations for sustained investment in AI infrastructure. With spending on AI development expected to continue through 2025 amid an “arms race” among major technology firms, market sentiment will likely hinge on the scalability and commercial viability of AI models released in 2025. Investors are likely to watch closely to see if these models seem to support additional spending on computing power. Beyond infrastructure, AI-driven efficiency gains and new product opportunities may further support earnings growth for select businesses.
Identifying “Value” as a Growth Investor
We believe these dynamics emphasize the need for selectivity. In 2024, multiple expansion contributed meaningfully to the return of the Russell 1000 Growth index, while earnings accounted for the entirety of Select Growth’s return, with over 57 percent of the portfolio trading at a lower 12 month forward price-earnings ratio as of December 31 relative to the start of the year. As shown in the graphic below, we see select businesses that trade at valuations that appear higher than their peers yet sit at equivalent or lower valuations based on consensus expectations for growth looking out two years. This dynamic is amplified when looking out over our five-year horizon and beyond.
Flight to Safety Presents Opportunities for Secular Growth
In our view, these relative value anomalies, paired with portfolio holdings with underappreciated levers to help deliver better-than-expected growth, provide opportunities to generate alpha and mitigate the risk that comes with elevated valuations.
Over much of 2024, investors were cautious, focusing on businesses exposed to the secular growth of AI and highly profitable, shorter-duration growth businesses. In our view, this provided an opportunity to take a longer-term perspective, as detailed above, to target businesses that we expect to combine strong revenue growth, improving competitive dynamics, and financial discipline in seeking to increase profits. With this in mind, we added to businesses with strong market positions within non-Amazon ecommerce, medical devices, streaming music, software, and gaming.
Moreover, the emergence of AI reinforces these dynamics. We expect AI to accelerate change, favoring businesses with foresight, scale, and proprietary data. We also expect the trajectory of AI infrastructure spending and the emergence of use cases to influence market sentiment and leadership. We see select opportunities in businesses with underappreciated opportunities to leverage AI and their existing platforms to deliver novel products or services and/or use AI to enhance efficiencies. In this environment, we expect a heightened bifurcation that favors managers with the foresight to monitor these developments while employing a highly discerning and nimble approach.
1 J.P. Morgan, 1Q25 “Guide to the Markets,” January 31, 2025, slide 6.
2 Bank of America, “A Productivity Boom is Not Priced In,” November 12, 2024
3 Goldman Sachs, “2025 Outlook: The Year of Alpha Bet,” November 18, 2024
Disclosures:
The views expressed are the opinion of Sands Capital and are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. The views expressed were current as of the date indicated and are subject to change.
This material may contain forward-looking statements, which are subject to uncertainty and contingencies outside of Sands Capital’s control. Readers should not place undue reliance upon these forward-looking statements. There is no guarantee that Sands Capital will meet its stated goals. Past performance is not indicative of future results.
All investments are subject to market risk, including the possible loss of principal. The strategy’s growth investing style may become out of favor, which may result in periods of underperformance. The strategy is concentrated in a limited number of holdings. As a result, poor performance by a single large holding of the strategy would adversely affect its performance more than if the strategy were invested in a larger number of companies.
A company’s fundamentals or earnings growth is no guarantee that its share price will increase. Forward earnings projections are not predictors of stock price or investment performance, and do not represent past performance. Characteristics, sector (and regional, country, and industry, where applicable) exposure, and holdings information are subject to change and should not be considered as recommendations.
The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients. There is no assurance that any securities discussed will remain in the portfolio or that securities sold have not been repurchased. You should not assume that any investment is or will be profitable. A full list of public portfolio holdings, including their purchase dates, is available here.
As of February 6, 2025, DoorDash, Shopify, and Block were held across Sands Capital strategies. Cintas, Costco, and J.P. Morgan were not held in any Sands Capital strategy and are referenced for illustrative purposes only.